General Mills, Inc. (NYSE:GIS) Q3 2018 Earnings Conference Call March 21, 2018 8:30 AM ET
Jeff Siemon - VP, IR
Jeffrey Harmening - Chairman & CEO
Donal Mulligan - EVP & CFO
David Driscoll - Citigroup
Andrew Lazar - Barclays
Kenneth Goldman - JPMorgan
Alexia Howard - Bernstein
Akshay Jagdale - Jefferies
Ladies and gentlemen, thank you for standing by, welcome to the General Mills Third Quarter Fiscal 2018 Earnings Conference Call. During the presentation, all participants will be in a listen-only mode. Afterwards, we will conduct a question-and-answer session. [Operator Instructions] As a reminder, this conference is being recorded today, Wednesday, March 21, 2018.
I would now like to turn the conference over to Jeff Siemon, Vice President of Investor Relations. Please go ahead, sir.
Thanks, Nelson, and good morning to everybody. I'm here with Jeff Harmening, our Chariman and CEO; and Don Mulligan, our CFO. I'll hand the call over to them in a moment, but before I do, let me cover a few items.
Our press release on third quarter results was issued this morning over the wire services and you can find the release and the copy of the slides that supplement our remarks this morning on our Investor Relations website. I will remind you that our remarks will include forward-looking statements that are based on management's current views and assumptions and that the second slide in today's presentation list factors that could cause our future results to be different than our current estimates.
And with that, I'll turn you over to my colleagues, beginning with Jeff.
Thanks, Jeff, and good morning to everyone. Let's jump right in and cover the key messages for today.
Our primary goal during fiscal 2018 has been to strengthen our top line performance while maintaining our efficiency; we're delivering on the first part of that goal with stronger innovation, more impactful consumer news and better in-store execution leading to a second consecutive quarter of organic net sales growth. We're also generating significant growth and free cash flow through strong capital discipline. As a result, we're reaffirming our full year organic net sales and free cash flow targets.
While I feel good about our results on net sales and cash, I'm disappointed in our profit performance this quarter. Our third quarter operating profit fell well short of our expectations and our full year outlook has been impacted by an increase in supply chain costs in a dynamic cost environment. We're moving urgently to address these rising cost pressures, we've taken actions to improve profitability in the near-term and we've launched initiatives that will reduce our long-term cost structure. While these actions will only partially offset the cost headwinds in fiscal 2018, we still expect to deliver profit growth in the fourth quarter; and we're confident these actions will strengthen our bottom line results beginning in fiscal 2019. Beyond our current results and outlook, we remain confident in our ability to drive long-term value with our consumer for strategy which will be further strengthened with the addition of Blue Buffalo to our family of brands.
Before turning it over to Don to cover our financial results, let me share some details on the cost increases driving our revised profit outlook, and the steps we're taking to mitigate these increased costs going forward.
Between incremental costs we identified as we closed the books in the third quarter and a more unfavorable cost outlook for the remainder of the fiscal year, we now expect our full year fiscal '18 total segment operating profit will be 5% to 6% below year ago levels in constant currency. The key driver of this change is a significant increase in supply chain costs which falls into two main areas; first, their input costs are rising faster than we had anticipated, in fact, we now estimate our full year fiscal '18 input cost inflation will be 4%, 1 point higher than our previous estimate.
We called out an increased freight costs that are upto CAGNY but the cost pressure we're seeing is even higher than we thought at that time. We're now having to go out to the spot market for close to 20% of our shipments versus the historic average of about 5%, and those spot market prices can be 30% to 60% higher than our contracted rates. In fact North American freight spot prices were near 20-year highs in February. Higher freight costs are impacting our raw material prices as well as the cost to ship materials from our suppliers to our factories has risen significantly. And we've seen higher prices in some key commodities including grains, fruits and nuts, further heightening the inflationary dynamic.
The second main area of supply chain cost pressure is increased operational costs driven by higher volumes running through our network. We've seen increased volume on some capacity constrained platforms and stronger results for our new products. And while I'm pleased with our increased volume performance, those factors are mainly utilizing more external manufacturing where conversion cost can be significantly higher than our internal platforms. Additionally, we've seen increased expenses from intra-network shipments between our distribution centers as we move more products to the right locations to satisfy the strong demand.
We're moving urgently to address this increasingly dynamic cost inflation environment and ensure that negative profit impact is limited to fiscal 2018. Some of the actions we're taking will have an impact already this fiscal year. We're addressing higher freight costs in the near-term by qualifying more carriers and utilizing different modes of transportation. We're placing increasingly tight control over all expenses in the balance of this year. We're also taking smart actions to drive positive net price realization in a higher cost environment by pulling various levers within our strategic revenue management tool box. The specific SRM actions will vary across categories and vary across geographies but will impact all four operating segments with benefits starting to hit this fiscal year, and more fully impacting fiscal 2019.
We're also moving forward on initiatives to address our structural cost for fiscal 2019 and beyond. We're optimizing our distribution network between the factory and the customer to better align with the manufacturing footprint reorganization we completed over the past 3 years. We've improved additional cost savings initiatives design to further optimize our global administrative structure, and will continue to drive other savings efforts that will improve our efficiency including our ongoing holistic margin management program, our global sourcing initiative, and other enterprise process transformation projects. In addition to these profit actions, we will maintain our focus on driving -- on improving our net sales through our compete, accelerate and reshape priorities because we know our job is to deliver both the top and the bottom line.
Before I turn it over to Don, let me assure you that we understand the ramifications of changing current year outlook in such a short period of time, and we are taking steps to ensure this doesn't happen again. Our forecasting process has historically relied on a periodic in-depth analysis, a key juncture during the fiscal year; and at more stable times that cadence served us well in forecasting our cost and margins. In an increasingly dynamic environment we need to go deeper more frequently, while that would not have reduced the cost, it would have accelerated our mitigation efforts by a quarter or so. So while we're moving with urgency to address these higher costs, we're moving with equal urgency to adjust our forecasting process at all levels of the organization.
Now let me turn it over to Don to provide more details in the quarter and our updated outlook.
Thanks, Jeff and good morning, everyone. Slide 8 summarizes third quarter fiscal '18 financial results.
Net sales totaled $3.9 billion in the quarter, up 2% as reported, organic net sales increased 1%. Total segment operating profit totaled $628 million, down 6% in constant currency. Net earnings increased a 163% to $941 million and diluted earnings per share increased 166% to $1.62 as reported. These results include a onetime and ongoing benefits related to U.S. Tax Reform. Adjusted diluted EPS, which excludes the onetime impacts related to tax reform and other items affecting comparability was $0.79, up 8% on a constant currency basis reflecting a lower ongoing tax rate in fewer average diluted shares outstanding.
Slide 9 shows the components of total company net sales growth. Organic net sales increased 1% in the third quarter driven by organic sales mix and net price realization. Foreign currency translation yielded a 2 point to net sales. Divestitures reduced net sales growth by 1 point reflecting co-packing sales made in last year's third quarter related to our Green Giant divestiture.
Turning to Slide 10; third quarter adjusted gross margin decreased 250 basis points and adjusted operating profit margin was down 120 basis points. As Jeff mentioned, we experienced a significant increase in supply chain costs including higher freight, commodities and operational costs, and we now expect our fiscal input cost inflation will be 4%, 1 point higher than our previous guidance. We also had higher merchandising activity in the quarter including greater than expected seasonal performance on soup and refrigerated dough and stronger merger results in cereal snack bars which more than offset the benefit of trade expense phasing from the prior year.
These margin headwinds were partly offset by lower SG&A expenses, including a 22% reduction in advertising and media expense in the quarter. Year-to-date, media expense is down 5% as we have shifted some dollars to vehicles closer to the point of sale including customer events, in-store theater, loyalty programs, sponsorships and sampling. Our million acts of good activation with Ellen is a great example of this type of standing. These initiatives get our brands in front of the consumer usually in the store that are captured in the media line in the P&L.
We expect our total consumer facing spending this year including media, as well as non-media vehicles like the ones I just mentioned to be roughly in line with prior year levels.
Slide 11 summarizes our joint venture results in the quarter. CPW net sales increased 2% in constant currency with growth across all 4 CPW regions, and strong performance on our granola and muesli product lines. Häagen-Dazs Japan, constant currency net sales were down 3% due to unfavorable net price realization and mix. On a year-to-date basis, constant currency net sales were up 1% for CPW and up 2% for Häagen-Dazs Japan. Combined after-tax earnings from joint ventures totaled $17 million, up 30% in constant currency, primarily driven by volume growth at CPW.
Slide 12 summarizes other noteworthy income statement items in the quarter. We incurred $11 million in restructuring and project-related charges in the quarter including $3 million recorded in cost of sales. Corporate and allocated expenses excluding certain items affecting comparability decreased $4 million from a year ago. Net interest expense was up $13 million, primarily driven by the early repayment of certain medium term notes which resulted from the Blue Buffalo acquisition. This onetime item is excluded from adjusted earnings. The effective tax rate for the quarter was impacted by a onetime provisional net benefit of $504 million related to tax reform.
Excluding items affecting comparability, the tax rate was 15.2% compared to 24.7% a year ago during by the lower corporate income tax rate resulting from tax reform, partially offset by non-recurring favorable discrete items in the prior year period. And average diluted shares outstanding declined 1% in the quarter. We continue to expect average diluted shares will be down approximately 2% for the full year.
Turning to our nine month financial performance; net sales of $11.85 billion were down 1% on an organic basis. Segment operating profit declined 10% in constant currency, and adjusted diluted EPS were down 2% in constant currency, including the impact of the lower corporate tax rate and lower average diluted shares outstanding.
Turning to the balance sheet; Slide 14 shows that our core working capital decreased 57% versus the prior year driven by continued benefits from our terms extension program. For the full year, we continue to expect our core working capital balance will finish well below fiscal '17 levels driven by significant improvement in accounts payable. Nine month operating cash flow was $2.1 billion, up 29% over the prior year driven by our working capital improvements. Year-to-date capital investments totaled $398 million and due to the first nine months of the fiscal year we returned nearly $1.4 billion to shareholders through dividends and net share repurchases.
Slide 16 summarizes our fourth quarter outlook excluding the impact of the proposed Blue Buffalo acquisition. We expect to deliver another quarter of organic net sales growth driven by positive price mix across all four segments. Remember that our results in Asia and Latin America segment will be negatively impacted by the comparison to last year's fourth quarter that included an extra month of results in Brazil, as we'll aligned net markets reporting calendar to our corporate calendar. We continue to expect accelerated cost savings in the fourth quarter driven by benefits from our new global sourcing initiative. That increased cost savings plus positive price mix and the initial benefit of the actions Jeff highlighted will help drive constant currency growth in total segment operating profit and adjusted diluted EPS.
I'll close my portion of our remarks by summarizing our updated fiscal '18 guidance. As I just noted, this outlook does not include any impact from the Blue Buffalo acquisition. We continue to expect organic net sales growth to be flat to last year. As Jeff mentioned upfront, we now expect total segment operating profit growth will be down 5% to 6% on a constant currency basis. Our full year adjusted effective tax rate is now expected to be approximately 26% or 1% below our most recent guidance. We continue to estimate the tax reform will have a 2 point favorable impact to our fiscal '18 adjusted effective tax rate.
Our updated full year adjusted diluted EPS outlook is in the range of between flat and up 1% in constant currency. We expect currency translation will add 1 point of growth to net sales totaled segment operating profit and adjusted diluted EPS in fiscal '18. Finally, we continue to expect full year free cash flow growth of at least 15% this year.
With that, I'll hand it back to Jeff to cover our segment results.
Thanks, Don. Now let's look at each of our segment results and talk a little bit about our upcoming news and initiatives.
In North America retail, organic net sales were up 1% in the third quarter. U.S. Snacks posted 3% net sales growth driven by Nature Valley, Lärabar and fruit snacks. The U.S. meals and baking operating unit generated 2% net sales growth behind the strong baking and soup season. Canada net sales were up 1% in constant currency led by our natural and organic platform. U.S. net cereal sales were down 1% reflecting reduction in customer inventory levels while cereal retail sales and Nielsen measured outlets were up 2% behind innovation and effective messaging across our core brands.
U.S. yogurt net sales were down 8% which represents the third consecutive quarter of improvement as our portfolio benefits from successful innovation and faster growing year-over-year segments. Constant currency segment operating profit was flat compared to the year ago period driven by higher sales, offset by higher input costs. As I outlined at CAGNY, our top priority for returning to consistent top line growth is to compete effectively on every brand across every geography. Growing with our categories is the first measure of success and I'm pleased to say that we have accomplished that in the U.S. in the third quarter with retail sales up 1%, marking the fourth consecutive quarter of sales improvement; and we grew market share in 7 of our top 9 U.S. categories.
Our improvement is driven by solid fundamentals. Our baseline sales trends are 500 basis points better than last year and are driving 75% of our retail sales improvement. This is a result of good consumer news and strong messaging through traditional media like T.V. and digital advertising and Nature Valley, Pillsbury and Totino's, as well as the activations that go beyond traditional media like our Ellen partnership on Cheerios. We're also delivering better innovation this year with our average new product turning nearly 50% better on-shelf compared to last year. This includes chocolate peanut butter Cheerios which is the biggest launch in the cereal category this year, and WeBuy [ph] Yoplait which is the largest launch in the yogurt category this year.
The third leg of our improvement is our in-store execution. We were back in the zone on seasonal merchandising this year which grows significant improvement in soup and refrigerated dough. And we're winning a higher share of display, the best type of merchandising vehicle on some of our most productive categories including cereal and snack bars. These efforts are translating into broad-based improvement in our U.S. retail sales trends with absolute retail sales growth in 7 of our top 9 categories in the third quarter.
In addition to our strong fundamentals, we're maintaining a disciplined approach to our pricing. As you can see in the chart, our baseline and merchandise price points have been higher than last year throughout fiscal '18 including the third quarter. Our average unit price was slightly down in the quarter as our proportion of merchandising was higher this year. This was really driven by prior year comparison when our merchandising levels were abnormally low. When you look over a two-year period, our average prices across our portfolio were up 4% and are outpacing our aggregate categories. With that at the backdrop, let me share some third quarter highlights from North America Retail and talk a little bit about what's to come for the remainder of the year.
Our U.S. cereal retail sales were up more than 2% in the third quarter driven by the same things I mentioned the for the segment, better news and messaging innovation and execution in-store. There is no shortage of examples of good news and messaging on our cereal business this year. One of the most fun is our Marshmallow news on Lucky Charms which has helped drive double-digit retail sales growth so far this year. And we just announced our most recent initiative, Magical Unicorn Marshmallows which are in store now. On Cheerios, our partnership with Ellen and activation across TV, digital and social media on PAC and in-store and helped to improve our baseline sales growth nearly 400 basis points since the campaign first launched.
On Reese's Puffs we're launching a fourth quarter seasonal Bunnies version to help continue to double-digit retail sales growth that brand has enjoyed so far this year. And on the innovation front we've had a stellar year; we've launched chocolate peanut butter cheerios last October and it was the best-selling new product in the category last quarter. And we'll continue to look to bring fun limited edition seasonal flavors to Cheerios to the shelf with the launch of a new peach flavor that's rolling out now.
On U.S. yogurt, we've improved our retail sales trends by 16 points this year by innovating into faster growing spaces. Our retail sales were down just 3% in February and we actually grew a market share in the grocery channel last month. We're pleased with our U.S. yogurt improvement but we're not yet fully satisfied. We continue to improve by building on recent successes and by launching new category expanding innovation. For instance, we recently launched two new flavors of -- launched new flavors of WE by Yoplait and Yoplait mixins; the top two yogurt launches this fiscal year. And we have another important launch planned for this summer that addresses some of the biggest health and wellness fares in the yogurt category, you'll hear more about this news in the coming months.
Shifting to snack bars; Nature Valley has posted double digit retail sales growth this year and is generating more retail sales dollar growth than any other brand in the category. These results have been driven by innovation, nut butter biscuits and granola cups are the Top 2 new products in the category for the last two years. And we're seeing solid results from this year's launches, including new layered bars and filled soft bars. U.S. retail sales for Lärabar are up 30% this year behind our real food advertising campaign, and they're up almost 70% in Canada. We're also driving improvement on Fiber One by communicating what consumers value most about the brand, permissable indulgence. Retail sales trends for Fiber One last month were 900 basis points better than our fiscal '17 growth rate, thanks in part to our Brownie & Cookie Bites innovation.
Our soup and baking businesses rebounded from a challenging fiscal 2017 to good retail sales and market share during the key season this year. We have great news planned in the fourth quarter on other meals and baking businesses. We just launched Totino's many snack bites adding more fun variety to this business that grew retail sales 9% in the third quarter; and we'll look to drive more visibility of for Old El Paso by securing 4,000 taco truck displays which will be parked in the front of the store where Mexican food merchandising performs best.
Finally, our North American national organic portfolio continues to lead our growth with third quarter net sales up high single digits including good performance on Annie's, Lärabar and EPIC.
In our Convenience Stores and Foodservice segment, third quarter net sales were up 3% driven by a low single digit growth for the focused six platforms and benefits from index pricing on bakery flour. The frozen meals platform continues to perform well, including the new Pillsbury stuffed waffle which is the top turning breakfast item in C-stores where we have distribution. And our cereal platform delivered mid-single digit growth this quarter driven by continued distribution gains. Segment operating profit was down 10% in the quarter driven by higher transportation and logistics costs, as well as commodity inflation.
Turning to Europe and Australia, third quarter organic net sales were down 1% with strong growth in snack bars offset by declines in other platforms. Constant currency segment operating profit was down 46% versus last year driven by significant raw material inflation and a comparison against 39% constant currency growth in last year's third quarter. Through the third quarter, our Europe and Australia segment is growing with it's categories. Our Snack Bars and Häagen-Dazs platforms are performing exceptionally well with double digit retail sales growth driving strong market share gains. And on yogurt, although our retail sales in total are down, we're driving growth in many of our core brands including Panier, Perle de Lait, Liberte and YOP.
The fourth quarter is a key innovation window across all of our primary platforms in Europe and Australia. In yogurt, we will be the first major brand launching into the kids organic segment with our leading Petits Filous brand. On Old El Paso, we're responding to the increasing number of gluten avoiding consumers by introducing new gluten-free tortillas and Mexican kits. We're launching new flavors to bring excitement to the freezed around Häagen-Dazs ice cream, and we'll continue to invest in T.V., media and Nature Valley snack bars to drive increased household penetration. In Australia in January we began advertising Fiber One for the first time which has helped drive 20% retail sales growth for the brand.
In our Asia and Latin America segment, third quarter organic net sales were in line with last year with good growth in our Asian markets offset by continued top line challenges in Brazil. While our improvement in Brazil has taken longer than we expected, we're making progress and delivered net sales growth in the quarter on some key businesses including Yoki popcorn and Kitano seasonings. The third quarter is typically this segments lowest operating profit quarter of the year which means even smaller or absolute dollar changes drive big percentage changes and results. Last year we earned a $10 million profit in the quarter and this year's result with a loss of $2 million. The $12 million change was primarily driven by lower volume and higher manufacturing and logistics cost in Brazil. We expect this segment will return to profit growth in the fourth quarter behind strengthening top line performance.
Our snack bars and ice cream platforms led Asia and Latin America net sales performance in the quarter. Net sales for our snack bar business in India more than doubled in the third quarter driven by continued distribution expansion of our Pillsbury Cookie Cake and the launch of a new Pillsbury Pastry Cake. We're also launching a similar pastry cake to our Middle East markets under the Betty Crocker brand. Häagen-Dazs retail sales increased high single digits to last 3 months in Asia driven by our mochi innovation and activation during the holiday season.
Looking ahead, our refreshed Häagen-Dazs packaging is rolling out across Asia and we're supporting this with a campaign to celebrate the extraordinary creations of artisans around the world. We're also launching spring limited edition of flower flavors, cherry blossom, and lavender blueberry; and will support them with an omni-channel activation including in our shops. At CAGNY, I outlined our compete, accelerate, and reshape framework for restoring consistent top line growth; and I just shared how we're competing more effectively in fiscal '18 across many of our brands and geographies. We've also taken a significant step this year to reshape our portfolio with the acquisition of Blue Buffalo pet products.
Before I close, let me refresh you on the details of the transaction and share why we're so excited about adding Blue to our family of brands. Last month, we announced our intent to acquire Blue Buffalo for $40 per share representing an enterprise value of roughly $8 billion. Blue Buffalo is a highly attractive asset playing in the fast growing wholesome natural pet food category with $1.3 billion in revenues, 25% EBITDA margins, and a consistent history of double digit growth on the top and bottom lines. After the deal closes which we expect will occur before the end of May, Billy Bishop, the current CEO of Blue Buffalo will lead a new pet operating segment for General Mills.
Blue Buffalo is a truly unique asset in an attractive category that is still in the early stages of transformation. At $30 billion in sales in the U.S. pet food market is one of the largest in the center store. It has generated consistent growth and strong profitability over many years with low private label exposure. These days more and more pet owners, especially millennials see their pets as another member of the family; this humanization of pets combined with a growing consumer interest in more natural products has driven a dramatic increase in what we call the wholesome natural pet foods category. And this transformation is still in the early innings with wholesome natural products still making up only 10% of total category volume, up from 5% five years ago.
What's most exciting to us is that Blue Buffalo is leading the category transformation. The Blue brand has the strongest brand equity in the category with a clear number one position in the wholesome natural pet food, as well as the number one overall pet brand in the e-commerce and pet mass channels. And Blue is still on the early stages of expanding into the broader Food, Drug and Mass or FDM channels which represent fully half of pet food retail sales in the U.S. Since the announcement that has some analysts and investors asked me isn't this a new category and how will General Mills create value in this transaction? I think they've been pleasantly surprised when I explained that in many ways pet food is not a new category as some people think, their value creation playbook will look similar to the one we've used very successfully for the Annie's acquisition over the last three years.
Our industry leading retail sales force, retail partnerships and sales capabilities will help increase the likelihood of success of Blue's FDM expansion. We will also leverage our technical capabilities and extrusion and thermal processing to drive innovation across dry and wet pet food. We'll utilize our sourcing expertise and distribution network to enhance Blue's supply chain efficiency. We look for ways to help the Blue Buffalo team nurture and grow this modern authentic 21st century brand and will stay out of their way where they don't need us.
Finally, we'll be selective in where we can drive admin synergies with a focus on back office and public company costs. We took a very similar approach to Annie's and it resulted in net sales doubling and a little over three years since the acquisition. And I can tell you, for even have a successful at Blue Buffalo, our shareholder will be very happy with this acquisition.
Over the past month key leaders from my team and I have spent time in Connecticut with the herd, as they call themselves, and Billy and his leadership team have visited our marketing, sales and R&D teams in Minneapolis. The more we get to know each other, the more we see how compatible our cultures are and how synergistic our capabilities are in a variety of functional areas, and we cannot wait to get moving on continuing to grow this terrific brand as part of General Mills portfolio.
Let me wrap up by summarizing today's comments. We're competing more effectively in this translating into good momentum on the top line of fiscal 2018. At the same time, we've been challenged by sharp increases in supply chain costs that have negatively impacted our bottom line outlook. We're moving with urgency to address these rising costs with some actions taking effect now and more significant impact expected in fiscal '19. And finally, we're excited as ever about Blue Buffalo are we're confident that this transaction will deliver long-term value for our shareholders.
Now let's open the call for questions. Operator, will you please get us started.
[Operator Instructions] Our first question comes from the line of David Driscoll with Citi. Please proceed.
Given the given retail environment, I get just a lot of questions about pricing and the ability for manufacturers to realize pricing at retail. So you have profit challenges that you're talking about because of inflation; Jeff, I think a lot of people are really going to wonder is this because of the inflation side or is it because you just can't get pricing at retail? And then I think what you were saying on the call is, maybe there was a bit of an internal failure to recognize the higher inflation as quickly as you would probably expect your organization to do so but I would really emphasize the fact that investors just worry so much that the retail environment is so difficult that companies like NUF [ph], can't get pricing.
So I'd really appreciate your thoughts on that question and just a little bit more explanation on what happened here? And then how it really goes forward if you do in fact have the ability to recognize some price increases?
Let me start out by the addressing the pricing environment and kind of what we're doing to offset our cost just in general, then I'll turn it over to Don if he has any more specifics. In terms of the pricing environment, first of all, I would say is that we will address our increased cost by a combination of factors which starts with addressing our cost structure itself and there are some near-term things we can do with supply chain, there are some longer things we can do in terms of our logistics network. And we have our ongoing HMM program in addition to what we're doing with ramping up global sourcing; so that's -- kind of the first-line of defense against rising costs is to make sure we're managing our cost effectively, and rest assured that we're doing that and moving with an increased sense of urgency since discovering that we'll have higher input cost than we had thought.
On the net pricing realization; I can imagine people listening could be nervous because we took pricing a couple of years ago and that didn't exactly go out as planned. You know, what I would tell you on that is a couple of things; first is that the environment now is very different than two years ago, and the environment two years ago when we took pricing there was really a deflationary pressure on input costs and now we see an inflationary pressure and as I said we're looking at our input cost going up by 4% and then a lot of the spot market for commodities are that high or even higher. So we see a very different environment from that sense. What I will also tell you is that what we see on the logistics side is very real, and our customers face it all the time and we get a lot of questions from our customers because -- about what we're doing to offset logistics costs because they see the same kind of pressures in their business, so the environment is different.
The second thing is that I would say is, a couple of years ago we took more pricing than clearly we should have and we took about 5% pricing in fiscal '17 and you don't need that -- we don't need that kind of pricing to offset that kind of environment we have right now, just a little bit of pricing and our categories are already seeing 1% to 2% pricing consistently quarter-to-quarter; just a little bit of pricing combined with these cost measures will really help alleviate the pressure on our input cost.
And then finally, I would say that our capability is a lot greater than strategic revenue management now than it was two years ago, we've hired some people from the outside combining some internal experts; and -- so we can realize prices in a variety of ways and that includes trade optimization and price pack architecture and vision to some more of the traditional pricing; so we feel as if our capability is a lot greater than it was a year ago. In terms of costs and seeing the cost, Don, do you have anything that you want to add to that?
I guess I'll just finish the point that Jeff started about on pricing. If you look at our results year-to-date, we are seeing better competitives in the store but it's also being supported by pricing. Our Q3 organic positive price mix is higher than in the first half and for three of our segments it was up low single digits, and in our where it was flat as Jeff showed it was both our base and our merchandise prices were up; so the flat was more of a product of the mix of those. So we do believe it's environment's issue with the inflation where you can get price in Jet Blue [ph] to many of the instruments that we will use.
The other aspect to your question David was with visibility to our cost and again Jeff touched it upfront but I think it's worth going into again. Historically and this year, we've done deep estimates at our costs at regular intervals during the course of the year and that cadence has typically served us well in managing our costs and our margins. Frankly, if you look back over the years there has -- we seldom had a profit miss in year such as this one where our sales are tracking at/or better than planned. But clearly in hindsight, this year was a very dynamic cost environment, the combination of our higher volumes, some constrained platforms increasing inflationary environment, we should've gone deeper more frequently; it might not have reduced the cost but it would have gotten us out ahead of it faster.
As I look at it, we need to be just as agile in how we manage our cost structure as we've been this year in meeting consumer demands. And that's what we're focused on doing, the actions that we're taking now are to make sure that we get -- we address the cost structure in the marketplace but we're moving just as urgently to look at our estimating and forecasting process to make sure this doesn't happen again.
Don, one follow up; the first half of the year had a very sizable trade accrual phasing expense comparison issues; they were negative and it was supposed to get significantly better here in the back half. Given all that's happened on the cost side, I can't really tell what's occurred on trade phasing. Did the trade accruals perform as you expected? Can you give some color on that.
Yes, they did David. We had a headwind in the first half, we'll have a tailwind in the second half; it will actually -- that -- part of the reason that we're confident -- more confident in profit growth in the fourth quarter. In the third quarter, because we had very strong merchandising take at our seasonal businesses and in some of our other lines here in the U.S. because we had very strong offerings in the store; again, not lower price but better offtake from a consumer standpoint. And as I referenced, we are also moving more of our consumer funds to in-store activity which -- much of that is recorded as deduction to sales as opposed to in the advertising or the admin or SG&A line and the combination of those things offset the benefit from the tax accrual reversal -- the trade accrual reversal in the quarter.
Our next question comes from line of Robert Roscoe [ph] with Credit Suisse. Please proceed.
Don, I have to ask again about the presentation at Cagney and what kind of data you had at hand at that time because you did lower guidance for higher freight costs at that time, so you must have had some kind of a rollup of how much spot activity was going on during the quarter. So what was wrong with the data? I guess, that's the first question.
And then second, I guess broader on pricing; you do have on Slide 22 a chart that shows that your baseline pricing is still positive but it keeps decelerating, and it's now at 0.8%. You know, it needs to go the other way to offset all this inflation that you're talking about and I think you've kind of stopped short today of saying that you're looking at taking list price increases again; it seems like you're talking about revenue management and some other things but can we see some list price increases coming maybe in the back half? Thanks.
I'll hit Cagney one first. Obviously, when we gave our guidance in -- at Cagney, that was based on the best information we had at that time. I mention the fact that we do periodic costs deep dive, we did one in February, at the end of February, and we did it as we closed the books on the quarter in early March, and that is when these cost really came to the fore more clearly, and that's what's prompting the guidance change today. So as I referenced in the answer to David; we've done these at regular intervals, clearly in today's environment we have to do them more regularly and be more agile in terms of identifying the cost trends and make sure they are surface and acted upon, and we will do that.
In terms of pricing, we are going to use a number of leverage in some markets and some businesses; it's going to be list price increases. We talked at Cagney about our Convenience & Foodservice business, we're seeing the same in our European business, particularly in response to Brexit that can just have a ripple effect in the U.K. and certainly in some of our emerging market businesses. So that is part of the toolkit but again, the toolkit for our SRM is broader than that and we're going to use all the levers as we attack what is clearly a higher inflationary environment.
Our next question comes from line of Andrew Lazar with Barclays. Please proceed.
I know it's obviously too early to talk about specific sort of guidance and such for fiscal '19 but I guess I was hoping, maybe Don you could go through just a couple of puts and takes that we should be cognizant off, even directionally as we think towards -- I guess, more specifically how operating profit sort of shapes up for next year? Obviously, you've already talked about at Cagney, looking to reinvest; I think it was the majority of the benefit from tax reform, so that obviously has an impact around EBIT growth next year. But I was hoping you could -- because there is just so many factors that are playing into this today; anything you can get into around the puts and takes would be helpful.
Andrew, obviously I couldn't say FY19 guidance today, what I will say is that the actions that Jeff walked us through as part of the prepared remarks will have some benefit in FY18 and have more full benefit in FY19 and beyond frankly. And that will come into play as we think about '19. He did mention that the tax reform, that will give us some potential flexibility to reinvest back in the business and we still have -- we have the three planks that we are working to ensure that we drive a more competitive top line that compete, accelerate and reshape. I think you see in this year how we're competing better, we've begun to put some money behind our accelerator platforms, we see a little bit of benefit there this year and we'll see more of that benefit as we move into '19.
And then on the reshape part; obviously you talked about looking to divest a certain portion of the portfolio as well. Is that something that we think plays out over the course of the next -- call it year or so? I'm trying to get a better sense of a timeframe on that and obviously on some of these businesses I would anticipate you probably have a fairly low tax basis as well which I guess could potentially have an impact on EPS as well. I'm trying to get a sense of how to better think about that.
Our focus right now obviously is closing and transitioning blew into the family but we will quickly pivot following that to look at divestitures. Obviously, the timing of any divestiture would have to have a willing buyer to go with a willing seller, and we have to make sure the economics work to your point about tax rate. So we will work at that diligently and I believe just as we've been successful on the acquisition side with identifying and bringing Blue in, we will do the same on the divestiture side.
And when it comes to divestitures, I would also add to that is that -- I mean, we don't have to do all of the divestitures at the same time, I mean we can do those at different times. And the second is that we're only going to do that -- we're only going to do them when they make sense for shareholders and so when they are accretive to shareholder value. So we'll act with a sense of urgency but we will also act with a sense of our shareholders in mind to make sure that as we go to divest some businesses and that we're doing so at the night of that.
Our next question comes from the line of Michael [ph] with Piper Jaffray. Please proceed.
Just looking at the fourth quarter, you've had an operating income decline year-to-date around 9% or 10%, even with a little bit of currency; can you just help us understand how do you really get to -- looks like you need maybe another 10% in the fourth quarter; you've touched on some accelerating savings but can you just really give us a roadmap for how U.S. execute that sharp in improvement?
Sure, there is a few components to it Michel; it starts with another quarter of solid organic sales growth. As we look forward we expect mix to strengthen in each of the segments; cereal and snacks will be the driver in our and it also actually benefit from a little less from our meals and baking, our seasonal businesses. The focused six businesses in C&F will accelerate in the fourth quarter. Old El Paso, Häagen-Dazs buying the initiatives that Jeff talked about at EU, AU and Häagen-Dazs and snacks in Asia-LATAM. So we have good programs behind each of those areas that will continue to drive our top line growth. We'll add some net price realization, pricing in Brazil -- I mentioned C&F in the U.K. and then the various SRM initiatives we're executing in the U.S. and elsewhere. And again, we'll have to trade accrual reversal that will benefit the top line and our profit in Q4.
So that's really the main driver and when you translate that into profit you're going to have the benefit of that mix, the benefit of the trade realization; as well actually we also get the benefit of some volume leverage in Brazil as we improve our volume performance in that important market behind a couple of strong promotions, one around the World Cup. We'll get increased benefit from our global sourcing initiative that will increase our HMM in the quarter. And then, again, the other items that Jeff talked about particularly around our freight spending will begin to have some impacts, some favorable impact in the fourth quarter and the combination of those things in relatively equal measure, a little bit more from price mix but relatively equal measure across will benefit Q4 and help drive a profit growth figure for the quarter.
And is it fair to assume that would -- had initially at the beginning of the year been a headwind from higher incentive comp, maybe isn't anymore and could you quantify what that maybe doing to health?
Yes, that will be less of a headwind for the year. That is true and that will benefit the fourth quarter.
And then just lastly, on the portfolio when you think about some divestitures you've got at the moment this logistics and freight pressure, you also have dry, refrigerated and frozen supply chains; does reducing that complexity come into your thinking at all and how you evaluate what you may think about divesting?
It doesn't come into play into what we think about divesting but when -- as we're thinking about our supply network, we need to think about what we're divesting as we think about retooling that. And so it's a really good question, and it doesn't think -- it doesn't impact what we would intend to divest but it would have an impact on how we think our logistics network ought to be set up going forward; and so we think about those two things going together.
Our next question comes from the line of Kenneth Goldman with JPMorgan. Please proceed.
I just wanted to follow-up a little bit on Dave Driscoll's question earlier because I think the answer focused on now versus two years ago but if you go back a little longer in time, go back to fiscal 2008, Mills had 7% inflation, yet it still beat it's earnings target; fiscal 2009, 9% inflation, gross margin barely changed. I know you guys were in different seats at that time but something has changed; and I -- again, to Dave Driscoll's question, is it just this much harder to take less pricing no matter what or is it more a case of -- maybe items like freight, items on that sort of perimeter like -- that are not exactly foodstuff oriented are harder to pass?
I'm just trying to get a sense of really -- I know you've addressed it to some extent but Dave is right, this is really the question we're getting a lot, really, what the problem is this time because the inflation is not nearly as bad as what you experienced 10 years ago and yet the results are much worse.
A couple of things; you referenced 2008 and [indiscernible] was sitting in the cereal chair in 2008 which is when we did right size, right price; which is kind of a fancy term for price pack architecture. So when you think about strategic revenue management that was kind of the mother of all strategic revenue management initiatives, and so when I talked about price pack architecture and trade optimization and those kind of things; 2008 was a year that we certainly did that in the cereal business and saw great results from that; so a lot of positive lessons to be learned from that. I would tell you what's different about now is that the inflation as you mentioned; 4% is certainly a point higher and significant inflation above 3% but it's not something that can't be managed, we just had to make sure we see it coming, and now that we know that it's coming now we feel like we can manage it effectively because as the input costs rather 4% or 5% is not unprecedented, it's just higher than we had expected and we hadn't taken the actions to offset it.
Now that we see it, we have a pretty good degree of confident that with combining our -- but we can save on logistics costs in a way that we can reframe our logistics network combined with a little bit of net price realization, we can actually combat this because as you've said, we've done it before, we just didn't had the line of sight to it until room until recently that we needed to have to combat it.
And a quick follow up for me; you're using more co-packers I think than you expected but you're also hopeful that your volumes continue to rise. If this is the case, if your volumes do improve then you'll need to rely even more on co-packers which I'm sure you don't want. So as we think about 2019 and beyond, again, you're not giving guidance but is it reasonable for us to expect you want to invest in CapEx a bit otherwise I guess co-packing issue will just accelerate further?
We've always used co-packs specifically for a lot of our new product volume because there's a lot of times ready capacity and capability, and obviously there's a bit risk mitigation from our standpoint as well. And then what we've seen is that as the new products become stable in the marketplace, then we bring them internally and we see savings, and that's the way we put capital against and we'll take the same approach here. It doesn't necessarily mean that CapEx will be higher than normal, we just maybe skewing more towards bringing this new product volume in-house.
Our next question comes from Alexia Howard with Bernstein. Please proceed.
So I guess, to begin with it actually looks that though the profit pressure is greater in the international market at the moment and yet a lot of the conversation has been about perhaps not realizing the kind of profit, one's that you might have expected in North America resale. I'm just wondering if you can just go region-by-region and talk about what's happening to the profit declined in the international market?
And then secondly, on the Blue Buffalo acquisition; do you have a new updated guide on where the leverage might go to in light of the EBIT shortfall that's here? Thank you.
It tends to hit both regions. In the EU/AU the year-to-date margins are being impacted primarily by raw material inflation, especially dairy and vanilla which have spiked significantly this year. And we have some currency driven inflation on products imported in the UK, so some transaction effects. And both of those are particularly pointed in our UK; in our EU/AU business this year. As we look at Q4, we expect to see some improvement, we're going to get some price mix improvement, I mentioned that Old El Paso and Häagen-Dazs will lead the growth and those are both higher margin lines. We do see moderating input cost in EU/AU, a little bit different than here in the U.S. as they lap some of the initial spikes in the dairy and vanilla costs from a year ago.
We're going to see increased cost savings, I mean one of the manufacturing consolidation projects that we've had underway was in EU/AU and we're still in the first year seeing those saving, so those will increase. It will be partially offset with some higher media and advertising expense to support that top line but we expect to see improvement in the fourth quarter. And as I mentioned that actually, frankly, a lot of the same factors in terms of transaction FX -- maybe more unique factor [ph] because Brazil is lower volumes as well. And so as we look at Q4, we're going to see improvement because we're going to get better price mix, we'll need better volume performance in Brazil as we come out of any ERP installation and the COGS headwinds will lessen a bit.
So that's in the quarter but I think your question's a broader one as well; and I think it is a good one. As we look at those two segments; we're very pleased over the long run with our top line, we've been very competitive and actually market leading in both of those areas over the longer term at our topline growth, and we have been investing in those businesses to maintain that growth or drive that growth. And I think we have the opportunities we go forward to better balance the top line growth in the margin performance, and so as we build our FY19 plan and beyond, that's soon to be something that we have in mind in both of those regions.
And then on the leverage?
On the leverage, it may go up a tick because of the lower profit. I think we've got at 4.2%, 4.3% it moves, it'll be by 0.1%.
Our next question comes from the line of Akshay Jagdale with Jefferies. Please proceed.
I wanted to sort of unpack the profit equation a little bit and I need your help in understanding what you think is transitory versus structural, right? So you've got an issue with the commodity cost spiking and I think what I see is different from years past is; these costs that have gone up aren't hedgeable; so the visibility on them is inherently lower, so the reaction time I guess has to be faster. So in the months to come and the quarters to come, you'll have to show that your brand is strong enough to pass that on, so that will have to play itself out but what I'm more concerned about and the questions we get is, you're having this really nice performance and improvement on the sales side, how much visibility do you have on the incremental profitability from these new products and the sales growth that you're seeing?
Is this -- are these inherently lower profitable products or how are you thinking about that because you've had some issues with the visibility, I wonder if this sales growth is coming at any cost -- is it a competitive issue? I'm just trying to better understand that because it has major implications going forward. Thank you.
We obviously look at all of our new products in terms of their incrementality both from the top and the bottom line. We as a great example where we're generating more out of per cup basis on our base product even though the margin percentage themselves are not materially different but you have a higher price point. So what we're seeing this year is our new product volume is performing very well, as Jeff showed almost 50% better than a year ago. And because we do those externally and because we're seeing also the need to from a co-packer standpoint and within our logistics network, more miles as we reposition product to meet consumer demands, we're having additional cost accrued to those businesses. It's not naturally because of the new product economics, i.e. as we bring those in-house, as we structurally change our logistics network, the margins on those products are going to be very competitive with our current business but it's a matter of getting the structure right and as Jeff alluded to, that's one of the projects that we have underway to enhance our entire cost structure and that will accrue to the benefit of many of these new products that are driving the higher volume.
I will put a final point on that, I think it's a good question actually but you know, I want to reiterate; one of our top line performers, particularly North America retail and C&F in Europe Australia and even Asia, I couldn't be more pleased with the way that we have been able to pivot and grow our top line and the economics behind that and there have been a lot of questions about that and the environment and did we buy a volume; I just want to unquivaocably say, I love the way they were executing, our sales and our marketing teams are executing well together, our marketing campaigns are better, our new products are together; so I'm displeased with our profit performance in the third quarter and the fact that we didn't see some of this coming as much as we should have but I am really pleased with what the organization has done about returning to growth.
You asked about the cost, I would say that I think from a logistics standpoint, I mean I think it is more structural. We have a tight [ph] labor supply, we have new regulations that started in December which will fully become operational in April, and we are hitting a moving target but I think our logistics costs are structural, I don't think that they are going to go down. And what we're seeing on the commodity side is certainly going up and that abs and flows overtime; I'm not sure that is structural as much as in this point in time but I think the logistics costs are which is one of the reasons why we need to have some net price realization, why we feel like we can because everyone is feeling it in the industry, our competitors are feeling it, we're feeling it, our customers are feeling it; and so as we look for net price realization, I think that part is structural.
And any implications from everything you are facing in your base business on how you think about integrating Blue Buffalo?
No, I'm glad you asked about that. First of all, I think about -- Blue Buffalo, I think of a transition rather than integration. I mean it's going to be -- Blue Buffalo is going to be a separate operating segment, and so they'll be some integration and the synergies we have accounted for actually quite low relative to other deals that we have done and so it will operate relatively independently and we'll help them on the sales side where we can, we will help them on the supply chain cost but I can tell you even over the last month since we've announced the deal and gotten their leadership team, they've got a very strong leadership team. And I think their strong leadership team not only has a vision but the rest of the team combined with our capabilities; I will tell you that even in the month since we announced the acquisition we feel more confident than we have even before about our ability to execute against Blue Buffalo well.
Unfortunately, I think we're past time, I know there's still a lot of questions out there; so please don't hesitate to give me a call later today. Thanks for everyone for joining us this morning and have a good rest of your day.
Ladies and gentlemen, this does conclude the conference call for today. We thank you for your participation, and ask that you please disconnect your line.